Why Sectors Matter
A stock doesn't exist in isolation. Its sector and industry provide crucial context for understanding its scores and potential.
The Sector Effect
Studies show that 40-50% of a stock's movement is explained by its sector. The rest is company-specific.
This means:
- A great company in a terrible sector may struggle
- An average company in a hot sector may soar
- Sector trends can override individual fundamentals
The Rising Tide
"A rising tide lifts all boats."
When a sector is in favor, most stocks in it rise. When a sector is out of favor, even good companies struggle.
Understanding sector dynamics helps you know whether you're swimming with or against the current.
How Sectors Affect Scores
Valuation Norms
Different sectors have different "normal" valuations:
- Tech: P/E 25-35 is normal
- Banks: P/E 10-15 is normal
- Utilities: P/E 15-20 is normal
A P/E of 20 is cheap for tech but expensive for banks.
Quality Benchmarks
Different sectors have different profitability norms:
- Software: 70%+ gross margins
- Retail: 25-35% gross margins
- Grocery: 25-30% gross margins
A 30% margin is excellent for grocery but poor for software.
Growth Expectations
Different sectors grow at different rates:
- Tech: 10-20% growth expected
- Utilities: 2-5% growth expected
- Healthcare: 5-15% growth expected
5% growth is great for utilities but disappointing for tech.
Key Takeaways
- Sectors explain 40-50% of stock movement
- Valuation, quality, and growth norms vary by sector
- Always compare stocks within their sector
- Sector trends can override company fundamentals
Sector Characteristics
Cyclical Sectors
Move with the economy:
- Financials — Interest rates, loan demand
- Industrials — Manufacturing, construction
- Consumer Discretionary — Spending on wants
- Materials — Commodity demand
- Energy — Oil prices, economic activity
Best time to buy: During economic pessimism Risk: Vulnerable in recessions
Defensive Sectors
Stable regardless of economy:
- Consumer Staples — Food, household goods
- Healthcare — Medical needs don't disappear
- Utilities — Electricity always needed
Best time to buy: When seeking stability Risk: May underperform in bull markets
Growth Sectors
Driven by innovation and expansion:
- Technology — Digital transformation
- Communication Services — Media, social platforms
Best time to buy: When growth is undervalued Risk: High valuations, competition
Sector Rotation
Markets rotate between sectors based on:
Economic Cycle
| Phase | Favored Sectors |
|---|---|
| Early Recovery | Financials, Industrials, Consumer Discretionary |
| Mid-Cycle | Technology, Industrials |
| Late Cycle | Energy, Materials |
| Recession | Utilities, Consumer Staples, Healthcare |
Interest Rates
- Rising rates: Financials benefit, Utilities/REITs struggle
- Falling rates: Utilities/REITs benefit, Financials struggle
Inflation
- High inflation: Energy, Materials, Real Estate
- Low inflation: Growth stocks, Technology
Don't Time Sectors
Sector rotation sounds great in theory but is hard in practice. Most investors are better off:
- Diversifying across sectors
- Focusing on individual stock selection
- Letting sector allocation happen naturally
Using Sector Context
When Analyzing a Stock
- Know the sector norms
- Compare to sector peers
- Consider sector trends
- Understand sector risks
When Building a Portfolio
- Diversify across sectors
- Don't over-concentrate
- Consider sector correlations
- Balance cyclical and defensive
Sector Traps
- Comparing stocks across different sectors
- Ignoring sector headwinds/tailwinds
- Over-concentrating in one sector
- Chasing hot sectors at the top
Next up: Comparing stocks within sectors—apples to apples.